If you’re considering pension drawdown before retirement you’re not alone. Figures from the Financial Conduct Authority showed a 10% rise in people choosing to access their pension early since between 2017/8 and 2018/9.
The Pension Freedoms announced by the then Chancellor of the Exchequer, George Osborne, which came into force in 2015, brought sweeping changes to the way that people could access their private pensions.
Pension drawdown rules
In a nutshell, if you have a defined contribution pension the Pension drawdown rules allow you to:
- Access your pension from 55
- Take up to 25% as a tax-free lump sum (you don’t have to take this in one go, it can be phased)
- Take the rest of your money as taxable income, either in one lump sum, multiple lump sums or
- Take your pension as flexible income over your retirement
Taking your drawdown pension as income
You can take your drawdown pension as income to support you through retirement from the age of 55.
You can:
- opt to take it as a monthly income.
- Adjust the amount you receive and
- Take as much or as little as you like
- Cash in your whole pension*
Once you have taken all of your tax-free cash, you’ll be taxed at your highest marginal rate of income tax.
* Remember that whatever money you take from your pension in one tax year (after your tax-free cash), will be classed toward your taxable income.
If you are still working or receiving your state pension (or both), it will sit on top of any money already earned, so be aware that taking income from your pension could push you into a higher tax bracket.
Over 55 pension drawdown before retirement
The rules surrounding when you access your pension through drawdown are clear – You must be over 55 in order to access your pension. It’s not usually possible to flexibly access your pension before the age of 55 – although in some rare case you may have a protected retirement age that’s lower than 55.
If you have a pension with a protected retirement age below 55, you will have the option to use pension drawdown at your scheme’s retirement age.
Please be aware that most firms/websites that claim to allow you to access your pension before the age of 55 are a scam. People have lost their entire pension doing this – it’s not worth the risk. If in doubt speak to PensionWise before you do anything.
Pension drawdown benefits
The benefits of pension drawdown lie mainly in its flexibility. Historically, when people retired they would use their pension pot to buy an annuity, which guaranteed them an income for life. However, as people are living longer, annuities have become increasingly expensive, and less generous and as such, demand has dropped.
Whilst annuities can still be a good idea for risk-averse investors, Individuals are preferring to invest their pension pot to provide an income in retirement.
The main benefits of pension drawdown before retirement are:
1) Flexibility
As the name suggests flexible-access drawdown means you can access your money flexibly and take it as and when you need it.
2) Semi-retirement and phased retirement
Linked to flexibility, once you hit 55 you can access your pension and use it to fund semi-retirement. Or supplement your income for phased retirement. It’s possible to work and take your pension at the same time.
Read more: Can I take my pension at 55 and still work?
3) Take more money when you need it and less when you don’t
Many have used their tax-free cash to clear a mortgage or debts so that they can go into retirement free of financial constraints.
If you’re retiring before your state pension is payable, you may opt to take more from your private pension until you start receiving your state pension and then take less.
Equally, if you wish to travel, or enjoy other activities in early retirement, you could opt to take more money in the early years and less money when you are less active.
It’s important to manage how much you take, so that you don’t run out of money.
4) Tax-efficient planning – using your personal allowance
Research published by Hargreaves Lansdown shows that nearly half of all people accessing their pension are choosing only to take their tax-free cash.
If you are still working, taking cash from your pension could result in you paying significantly more tax, and it could also trigger the Money Purchase Annual Allowance, limiting your ability to continue building your pension.
The flexibility of Pension Drawdown means that you could use your tax-free cash or part of your pension to supplement income or help you retire earlier.
You can adjust the amount of money you take from your pension pot in line with any other income to keep yourself from going into a higher tax bracket. Traditionally with a fixed annuity, this wouldn’t have been possible.
How much tax will I pay on my pension? Find out with these Pension tax calculators.
How long will my pension last? (calculator)
One of the drawbacks of drawdown is the uncertainty of knowing how long your pension will last. A flexible access pension is not a guaranteed income. It’s a balancing act of taking what you need but leaving enough invested to keep growing your money over time.
Once you’ve spent your pension pot, it’s gone.
How long your pension will last will depend on how much money you take from your pot and how your pension is invested. Taking too little investment risk can be just as damaging as taking too much risk, both could leave you short in the long term.
Our Pension Drawdown Calculator uses historical UK financial market data to show you how long your money might reasonably last.
Remember: Past performance is not an indicator of future performance and this tool should be used as an indicator only.
Pension drawdown vs taking your tax-free cash
Pension drawdown is slightly different from taking your tax-free cash.
Firstly, there’s the taxable element: 25% of your pension is tax-free. Income taken from the remainder of your pension is taxable at your highest marginal rate of tax.
If you’re confused about how much tax you might pay, try one of these pension tax calculators.
Secondly, there are the rules around funding your pension.
If you just take your tax-free cash you can still fund your pension for the full amount (currently £40,000 a year). So, it’s possible to take your tax-free cash, but carry on working and continuing to build your pension pot for retirement.
As soon as you go into pension drawdown and are taking your pension as income you’ll trigger the Money Purchase Annual Allowance (MPAA) and you will be limited to paying in just £4000 per year.
Once you’ve triggered the Money Purchase Annual Allowance, there’s no option to go back and take advantage of the previous pension saving limits.
Do you pay tax-on pension drawdown?
Yes, but you only pay tax on the taxable element of your pension. 25% of your pension is tax-free – the rest is taxable at your highest marginal rate of tax – so if you’re already a higher rate taxpayer you’ll pay 40%.
As a pensioner, you still get your personal tax allowance every year – £12,500 in 2020, so if your pension is your only income, even if you’ve already taken all of your tax-free cash, you’ll only start to pay tax, once your income exceeds your personal allowance.
Is pension drawdown before retirement a good idea?
Pension drawdown before retirement can be a great idea if it’s well managed. It offers far more flexibility than an annuity and since annuity rates have fallen in recent years, it offers a more attractive prospect for those looking to retire younger.
The main concern for pension drawdown is the worrying number of individuals opting to self-manage their pension investments, despite having no prior investment knowledge.
This is where experts are warning there could be problems, with one 2018 report suggesting over half could run out of money before the end of their retirement.
Inexperienced investors trying to navigate pension drawdown without financial advice may come up against some common pitfalls of pension investment.
Pitfalls of drawdown
- Taking out all of your tax-free cash and leaving it in a bank account for it to be eroded by inflation
- Taking too much money too soon.
- Paying too much tax unnecessarily
Our pension and investment specialist Simon Garber says “Some people have developed a deep mistrust of the financial industry and pensions in general. They don’t trust the government not to change the rules around tax-free cash, so many have withdrawn all of their tax-free cash early just for it to sit in cash.
Not only does this mean that this money isn’t invested where they could be growing their pension pot, but the value of cash is also subject to erosion by inflation. They believe that cash is risk-free but when it comes to long-term investing, cash is pretty much a guaranteed loss”.
Taking large amounts out of your pension to sit in your bank account also creates potential inheritance tax implications.
There’s also the risk of taking too much, too soon and taking the cash in a way that could leave you paying more tax than necessary. A financial adviser will help you navigate this complex area.
PENSION DRAWDOWN ADVICE
A third of individuals opting to use pension drawdown have no experience of investing, of those 41% are not receiving advice or guidance (source: Zurich), with a concern that over half of those in Pension drawdown could run out of money in retirement.
We offer bespoke pension drawdown advice, including advice on how much to safely withdraw from your pension, tax-efficient pension withdrawals and we are able to advise on the latest pension rule changes that might affect you .
You can book a free introductory call with an Independent Financial Adviser and pension specialist here.
